Is India’s current economic slowdown due to cyclical or structural factors?

Sarah Chan15 September 2012

Optimism over India’s economy is fading. This column argues that India’s current economic slowdown reflects both cyclical and structural factors. It outlines the steps needed to get India back on course to reaching its growth potential.

Investor confidence has also waned amid growing political uncertainty, and is reflected in the decline of the rupee and the stock market. Since the beginning of 2011, the rupee has declined by 25% against the dollar. It is the worst-performing currency in Asia ex-Japan, despite recent government efforts to halt its slide by raising the ceiling on foreign investment in rupee-denominated debt. India’s economic woes appear reminiscent of the crisis in 1991 when the country, facing bankruptcy, was forced to airlift its gold reserves abroad to secure emergency IMF loans.

A stagflation-type environment is emerging in India. GDP growth has slowed sharply to 6.5% in the fiscal year ending March 2012, from 8.5% in the previous year. Inflationary pressures remain persistent despite the Reserve Bank of India (RBI) hiking the repo rate 13 times by a cumulative 375 basis points since March 2010. Although the latest figures show headline inflation to have eased to 6%-7% in July 2012 from the highs of 9%-10% over the last two years, the moderation was mainly on account of the cooling in food and fuel prices. Inflation is still significantly above the RBI’s comfort zone of 5%-6% and underlying inflationary pressures remain strong – the RBI has recently warned that inflation risks remain high in the short term owing to suppressed administered fuel prices as well as infrastructural bottlenecks in coal, minerals and power (Reserve Bank of India 2012). Poor monsoon conditions are also likely to have an adverse impact on food prices and, as a consequence, wages.

India’s deteriorating growth-inflation trade off underlines the macroeconomic imbalances and structural weaknesses of the economy.

First, the twin deficits create a level of vulnerability for India that is a cause for concern. India’s expansionary fiscal policy, intended to fight the 2008 global credit crisis, has led to a dramatic deterioration in the country’s fiscal situation. Government spending in the form of several social programmes (particularly the National Rural Employment Guarantee Program or NGERA, which gives 100 days of minimum wages to the rural unemployed) to boost domestic demand has strained the government’s budget position, causing the overall fiscal deficit to widen from 4% in FY2007-2008 to 7% in FY2011-2012 (Figure 1). With sluggish economic growth and the consequent loss in tax revenues, the risks of fiscal slippage are high. The fiscal outlook has also become more tenuous since it will be difficult to rationalise subsidies if food inflation were to accelerate sharply in response to a poor monsoon. Fiscal imbalances pose risks to macroeconomic stability and undermine growth (IMF 2011) – a persistently high fiscal deficit will raise interest rates for the private sector and constrain the government’s ability to implement any stimulus measures to prop up the economy when growth slows, as is happening now.

Figure 1. Fiscal revenue, expenditure and deficit

Source: Ministry of Finance, CEIC

While the approach of stimulating domestic demand via fiscal expansion in 2008 put India’s economy back on track after the global financial crisis, the inertia in withdrawing stimulus has subsequently led to a spike in inflation that prompted monetary policy tightening and dampened aggregate demand. Gross investment (especially private) and savings slowed as a result. Total savings declined from the peak of 36.8% in FY2007-2008 to 32.3% in FY2010-2011, a decline of 4.5% of GDP, which exceeded the fall in gross investment of 3% of GDP during the same period. Reflecting the widening gap between savings and investment, India’s current-account deficit increased in the post-credit crisis period (Figure 2). The decline in total savings, a large part of which stemmed mainly from the erosion in public savings due to falling government revenues, has pushed the current-account deficit to the highest level since the 1991 balance of payments crisis. During the 12 months ending March 2012, India had a current-account deficit of $78.2 billion or 4.2% of GDP. This diverged from the current-account deficit, which ranged from -0.5% to -2% of GDP that policy makers have been conservatively maintaining since the 1991 balance of payments crisis. Historically, India has run a current-account deficit primarily due to the policymakers pushing investments and growth higher than that supported by the domestic saving rate. After FY2008-09, however, savings have been declining at a much faster rate than investment.

Figure 2. Current and capital account

Source: CEIC

A widening current-account deficit could potentially lead to pressures on the country’s balance of payments and the currency. Although India’s current-account deficit has been offset by capital account surpluses, nearly three-quarters of the deficit for the past four years was estimated to be financed by more volatile sources of capital, including commercial loans, trade credit and portfolio equity and debt inflows (Figure 3). Net foreign direct investment (FDI) inflows, which plunged 58% to $3.83 billion in the first three months (April-June) of FY2012-13, run the risk of slowing further due to regulatory uncertainty and corruption-related scandals. The inability of the government to push ahead with the liberalisation of FDI limits in the multi-brand retail sector as well as the imposition of retroactive tax on foreign mergers have discouraged foreign investor interest and worsened business sentiment.

Figure 3. Net capital inflows

Source: CEIC

To compound these domestic challenges, the external environment has not been supportive. Weak external demand has weighed on India’s exports, and despite the recent currency depreciation, the country’s current-account deficit woes are not expected to diminish. According to a JP Morgan study, India’s exports are far more responsive to changes in external demand than to movements in the exchange rate (JP Morgan 2012). In addition, the inelastic nature of India’s imports, particularly oil, is likely to exert pressures on the current account.

Considering India’s high current-account deficit, the risk of slowdown in capital inflows will exacerbate the funding risks and currency depreciation pressures. India’s rising current-account deficit raises serious questions about its sustainability, particularly against the backdrop of volatile global conditions and volatile capital flows. The RBI recently carried out an analysis showing that with GDP growth of 7% a current-account deficit-GDP ratio of around 2.5% is sustainable (Reserve Bank of India 2012). With India’s current-account deficit already exceeding this threshold level, its external vulnerability is expected to rise further.

Further, India’s short-term external debt has increased with the recent depreciation of the rupee, raising the country’s exposure to external funding stresses and giving rise to concerns of a high debt service burden. At the end of March 2012, the ratio of short-term debt to total debt stood at 22.6% compared to 10.2% in FY1990-1991. High external debt, along with a deterioration of the net international investment position since the global financial crisis, has made the country more susceptible to external shocks. However, India’s foreign exchange (Forex) reserves are now considerably larger compared to 1991, with the ratio of Forex reserves to total debt standing at 85.1% versus 7% in FY1990-1991 (Ministry of Finance 2011). India’s ample foreign reserves provide some buffer against balance of payments pressures, with Forex reserves providing almost 100% cover to India’s external debt, or 7.1 months of imports (Figure 4).

Figure 4. External debt and reserves

Source: CEIC

Despite the weakening of growth momentum, inflationary pressures have persisted, driven by high commodity prices as well as structural demand and supply imbalances. Higher demand due to shifting dietary patterns and rising household incomes have led to higher food prices, which are further exacerbated by low agriculture production growth that has averaged less than 2% per annum in the past decade. In the near term, inflation will remain elevated due to the upward adjustments in energy prices as well as increases in minimum support prices for various crops. Inflation expectations are also expected to remain sticky, creating not merely upside risks to near-term inflation but also likely to lead to a surge in gold imports (which was a key factor worsening the current-account deficit over the last two years) to hedge against inflationary pressures. The persistent fiscal deficit and the declining rupee pose potential threats for further inflationary pressures.

Conclusions

India’s current economic slowdown reflects both cyclical and structural factors. A slowdown in the investment cycle, combined with supply constraints and a subdued external environment has caused growth to slow to below trend. With weak global demand for exports, India’s continued economic expansion will have to rely increasingly on domestic growth drivers. However, the pace of structural reforms has been slow due to political gridlock; after high-profile corruption scandals in recent years (notably the mis-selling of telecommunications licences in 2008), many key economic reforms have stalled as a result of slower government decision making. Further, in terms of policy response, the government faces a dilemma whereby high inflation have complicated the RBI’s management of the rupee while the twin deficits significantly limit the monetary space for more aggressive countercyclical policy measures.

If India persists with a lack of reforms to rectify the macroeconomic imbalances, it could inhibit the country's growth potential. The IMF has estimated India’s potential growth rate at a much higher 7½-8½% (IMF 2010), and underpinning optimism over the country’s medium-term growth prospects are favourable demographics and significant progress towards economic liberalisation since the late 1980s. To realise India’s growth potential, major structural reforms aimed at improving the investment climate are necessary. In particular, legislative initiatives concerning land acquisition and mining, tax and financial sector reform as well as FDI in multi-brand retail, are important for ensuring the sustainability of its high growth. To mitigate supply constraints and facilitate non-inflationary growth, speeding up reforms in the power sector is an urgent priority, particularly through better allocation of domestic coal via pricing and reform of electricity tariffs (IMF 2012). Given recent important personnel changes in the finance ministry, it remains to be seen if the government will finally bite the bullet on a host of long-awaited policy measures, thus delivering the crucial structural reforms needed to restore confidence.